To quickly recap the issue, India attempted to tax the $ 11.2 billion purchase of an Indian subsidiary between two non-Indian parties. Earlier this year, the Indian tax authorities lost this fight in front of India’s Supreme Court. The Indian government responded by enacting legislation retroactively imposing a capital gains tax on merger and acquisition deals conducted overseas where the underlying asset is located in India.

Among others, U.S. Treasury Secretary Timothy Geithner has pressed Indian Finance Minister Pranab Mukherjee for reassurances that US investors will not be subject to Indian taxes on years-old transactions. Mukherjee has attempted to soothe concerns, stating at an April 20 conference that older tax cases would not be reopened. According to Mukherjee, “No case can be reopened which is more than six years old.” He further added that “there is no uncertainty” in Indian tax law for foreign investors and that India would hold transparent, open discussions with those who have concerns about the law.

Right or not, the recent tax fight does not appear to be slowing Indian investment.

“We are seeing lots of outbound US investment in India right now,” says Lisa Sergi, a senior tax director at WTAS. “India remains a strong option for our clients in technology and manufacturing as an area with low costs and a terrific market.”

And as for the potential uncertainty of Indian taxes?

“There are clear laws on the books in India, but in practice, the government will fight and hold out until the client pays something more. But in that way, they are no different than California’s Franchise Tax Board,” says Sergi.

So there you have it: Indian tax uncertainty is no less onerous than our own.

And now, the exciting conclusion! This week, we focus on the most common mistakes and hidden traps incoming foreign nationals encounter when using a drop-off trust as part of their tax strategy.

1. Don’t be a control freak.

The most important thing to remember about drop-off trusts is that you may not retain control over its assets. You are completing a gift to a trust that benefits your descendants. If you retain the right to revoke or amend the trust, the trust corpus will be included in your US taxable estate.

2. Give up the benefits.

Because this is a completed gift to the future, you may not retain a right to possess, dispose, or enjoy any particular trust asset or income stream. This means you may not retain a life interest or annuity payment related to a trust asset. Similarly, a retained “reversionary” interest exceeding five percent of trust assets is disallowed. Even a retained power of appointment that allows you to designate beneficiaries in the future will be treated as an excess benefit that can cause the subject property to be included in your US taxable estate. Likewise, the power to change life insurance beneficiaries with respect to a life insurance policy that is owned by the trust will cause the attendant death benefit to be included.

That said, you may be permitted to retain a discretionary beneficial interest. This means the trustee may allow you to benefit from the trust assets, but you may not possess a right to legally force any such enjoyment. For example, an informal non-written arrangement with a trustee that allows you continued enjoyment of trust assets will defeat the trust’s independent nature and cause inclusion in the taxable estate. Also, if the trustee’s discretion is subject to a standard (i.e. for “support, health care, education, and maintenance”) that can be enforced by the settlor as a beneficiary, this retained right will cause inclusion. If, under applicable local creditors’ rights laws, your creditors can force the trust income to pay your debts, this feature will be treated as a retained right that causes inclusion.

3. Replace the trustee with a subordinate.

You are allowed to retain a right to remove and replace independent trustees. This power is often reserved to you as the designated “Trust Protector.” So long as the trustee is not “related and subordinate” to you, retaining this power will not cause US estate inclusion. Generally speaking, a trustee will be “related and subordinate” if the trustee is a close family member, subordinate employee, or a company owned by you.

A properly planned and structured drop-off trust should allow you to both enjoy trust assets as a discretionary beneficiary and preserve the benefit of removing assets from your future US taxable estate. If you have questions about setting up a drop-off trust, contact me.

Well, maybe it’s not “shocking,” but it may be a bit surprising. Last week, we discussed the estate tax planning benefits of “drop off” trusts for incoming foreign nationals. One major point to remember from that post is that a drop off trust will only work if it’s funded prior to your estate becoming subject to US estate taxes.

The question remains, when are you subject to estate taxes? Surprisingly, your subjectability to estate tax does not necessarily coincide with time you become subject to US income taxation.

While income tax residence is governed by a series of objective rules (the “green card” test, the “183 day” test, and a number of tax treaty modifications), estate tax “domiciliary” is determined by a much more subjective facts-and-circumstances test. This means your estate may not be subject to US estate tax even though you have already obtained lawful permanent residence status.

A US estate tax domicile is established if you: (a) are living in the US and have the intention to remain in the US indefinitely; or (b) have lived in the US with such an intention and have not formed the intention to remain indefinitely in another country. The focus on “intent” introduces a wide breadth of subjectivity (some might say “planning opportunity”) to when US domiciliary is established. Often, the determination can turn on the location of your primary residence and where you carry on your family, social, religious, and business relations and activities.

Some of the factors which the IRS examines are: (i) the length of time you spent in the US and abroad and the amount of your travel to and from the US and between other countries; (ii) the value, size, and locations of your homes and whether they are owned or rented; (iii) whether you reside in a locale due to poor health, for pleasure, or for political reasons; (iv) where your valuable or meaningful tangible personal property is located; (v) where your close friends and family reside; (vi) where your religious and social and civic affiliations are located; (vii) where your main business interests are situated; (viii) your visa status; (ix) your stated residence on legal documents; (x) your voter’s registration; (xi) your driver’s license issuing jurisdiction; and (xii) your income tax filing status.

So, let’s assume you, a foreign national, are comfortable with claiming non-US domiciliary status and that you want to go forward with a drop-off trust. What could go wrong? (Enter foreboding music.)

It can be tough to remember in an election year, but people still like to move to the US. When they do, new taxpayers are often surprised by our global tax system that taxes residents on their worldwide assets and income. With just a little planning before the person becomes a US taxpayer, his beneficiaries may actually get to keep a little of his hard-earned cash.

Enter the drop-off trust.

A pre-immigration trust (sometimes referred to as a “drop-off” trust) is a trust created in a non-US jurisdiction by a non-resident alien before he becomes a US taxpayer whose taxable estate includes his global holdings. By setting up the drop off trust, the trust grantor can effectively remove from his US taxable estate all his non-US assets since the initial trust transfer escapes US jurisdiction.

Before 1996, this strategy was even more effective because the grantor could also use the drop-off trust to avoid US income taxes on gains attributable to the trust assets. The trust, as a non-US person, would invest only in non-US source income, and would thereby escape US taxation.

However, in 1996 Congress caught up with this scheme, and instituted the so-called “five-year rule.” Under this rule, if a non-US person becomes a US person within five years after funding a foreign trust, then the foreign trust is treated as a “pass-through” grantor trust that attributes the trust’s income to the grantor himself. This rule essentially eliminated any income tax benefit from using a drop-off trust, since most immigrants don’t plan their US residency five years in advance.

Still, the estate tax benefits of a drop-off trust are very real. With careful planning, an incoming foreign national can effectively remove large portions of his wealth from US estate taxation by depositing those assets in a properly domiciled foreign situs trust. One important note: the trust’s creation and funding must occur prior to the moment the foreign national establishes his US domicile for estate tax purposes. As a result, planning with a US tax attorney before arriving in the US is crucial.

More about this process in Part Two of the series. Tune in next week for more exciting adventures in the world of International Tax Law!

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